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Investing abroad: Risks, rewards, and realities of international markets

April 16, 2014

Chris Philips, senior analyst in Vanguard Investment Strategy Group, discusses the global financial markets and events that are contributing to market volatility. Mr. Philips is the author of the recent Vanguard research paperGlobal equities: Balancing home bias and diversification.

The situation between Russia and Ukraine offers the most recent example of geopolitical tension causing volatility in foreign markets. For investors confronted with greater volatility risk, why even consider foreign securities?

Well, the upside is diversification, but I think beyond that what you do get is we have to have risk in our portfolios in order to generate returns. That risk is going to flare up from time to time, and this is one of those times where it does flare up and it's very noticeable in its execution in the portfolio. But we do want to maintain that ability to diversify our portfolios over time. So we don't want to view the instability/uncertainty worldwide as a cause to reduce exposures to global securities within the portfolios as we currently have them.

You recently published a white paper in which you said, the economies of "other developed countries are less than perfectly correlated with the U.S. equity market." What does that mean, and why is it a potentially attractive feature for investors seeking to benefit from diversification?

Well, correlation is a statistical measure in the mathematical sense of it. But what it actually means for an investor is that, for example, if the German economy isn't moving perfectly in sync with the U.S. economy, then having some exposure to securities that are driven by the German economy can diversify the returns of your U.S. securities. And we do see that worldwide—that benefit of having that differing exposure over time.

Last year would be a good example of that, where the emerging-markets segment of the world actually dramatically underperformed the U.S. and Europe or the Pacific. That's a lack of correlation in the marketplace. Now, you don't want things to go down, but that's the reality of the investing world, right? So that correlation benefit does lead to diversification. We do want exposure to global securities worldwide because of those benefits.

You also wrote that, despite the size of non-U.S. markets, U.S. mutual fund investors held, on average, only 27% of their total stock allocation in non-U.S. funds. What do you think accounts for this "home bias"?

I think it's important to say that if we looked at this ten years ago, that number would have been closer to 20%. The fact that investors have increased their exposure to non-U.S. stocks is a very good thing. But there are many reasons why investors might maintain what we call a home bias, a desire to have more exposure to their own securities. There are some rational reasons, but mostly it comes down to the behavioral aspect and that attitude of "I just like to invest in what I'm comfortable with and what I know."

Can you talk about the potential pros and cons of investing in both mature markets and emerging markets?

Obviously, the biggest pro would be the diversification you get and the ability to enjoy returns wherever they might fall around the world, assuming you have a global exposure in your portfolio. Some of the reasons why a country might be developed versus emerging get down to the sophistication and overall development of the economy, of market structures, such as how easy it is to trade in a given marketplace, or the legal protections you might have as an investor in that country.

For example, are you at risk of a government seizing your foreign capital? We've seen that from time to time. Argentina is a good example, where the Argentinean government seized foreign capital and decided they wanted to make it their own. That's a significant risk that you don't necessarily see in developed markets.

Some of those risks you would expect to be compensated for over time with higher expected returns. That tends to be one of the upsides of investing in those markets, but we need to understand that the risks don't just manifest in terms of volatility. There can be other risks involved with some of these emerging markets or even further, if you go down to frontier markets.

Could you speak to some of the factors investors should consider when they're thinking about international bonds?

Well, there's the developed-versus-emerging question with international fixed income. There's also the role of international fixed income in U.S. or domestic portfolios.

And when you think about the high-net-worth investor who's in a high tax bracket, the tax advantages of a municipal bond have significant benefits relative to the diversification you might achieve by going global.

If we jump back to the home bias question, there actually can be very rational reasons for a significant home bias for U.S. investors as it pertains to municipal bonds versus other types of fixed income securities.

Speaking of international bonds, let's talk about currency risk. Could you explain what it is and how to mitigate it?

Currency risk is, quite literally, the fluctuation of the dollar versus other currencies. Now, what that means is that, if you have an asset that's denominated in, say, euros or yen or pounds sterling, that asset is going to have a volatility to itself. It's going to move in price over time, but it's also going to be impacted by currency fluctuation. How well or how poorly is the dollar performing versus the pound sterling? That basically gets added on top of the asset performance in that asset's local currency.

Why that's important is that, particularly in fixed income, our research has found that you can really increase the overall risk, the overall volatility, of bonds themselves to the point where they actually look a lot more equity-like in their return patterns over time.

So we took it one step further and said that, yes, we believe you should be diversified into global fixed income, but we only believe that if you can effectively hedge out or mitigate that currency risk. We actually take an approach of hedging it using the derivatives market. We'll actually use one month forward to try to eliminate all that currency exposure, thereby preserving the actual performance of the underlying fixed income instruments.

The global bond market hasn't always been the friendliest place for the typical investor. Why was that the case, and how have things changed in the past several years?

Well, in the 1970s, '80s, and even early '90s, the global bond market was dominated by a few large players. It was primarily sovereign issuers—governments issuing fixed income instruments—and the big players in the marketplace would be large banks, insurance companies, large pension funds that are actually looking to hedge out various exposures in their portfolio. What that means is there's not a lot of trading that goes on. And so there wasn't a lot of liquidity in the markets themselves.

An investor might buy a bond and hold it to maturity, thereby not trading it at all over time. What we've seen over the last 15 years is, with the explosion of issuance worldwide, as companies and governments have issued a significantly greater deal of debt instruments, the liquidity has increased dramatically, because now you have more investors able and willing to invest in those bonds. That has spurred the growth in the mutual fund world. So we've seen a lot more mutual funds and ETFs that have launched to invest in these markets. They are more inclined to take an active approach in the portfolio. So more trading is involved. That lowers cost, increases liquidity, and, overall, we've seen that really benefit the end investor.

What are your thoughts about short-term versus long-term perspective when it comes to having a global investing outlook?

We saw this last year with performance in emerging markets. The short term is what everyone focuses on, for better or for worse. So when we're talking with our investing base, what we try to encourage is to take a huge step back and think about your objective. The objective of being globally diversified, whether it's in fixed income or equities, is to be more diversified rather than less diversified. Have more exposures rather than fewer exposures. If we are trying to react on a minute-by-minute or day-to-day basis, we're going to end up chasing our own tails. So the importance of focusing on that long-term strategic allocation could not be more critical than any point in time.

Notes:

All investments, including a portfolio's current and future holdings, are subject to risk.

Investments in securities issued by non-U.S. companies are subject to risks including country/regional risk, currency risk, and currency hedging risk, which is the chance that currency hedging transactions may not perfectly offset the fund's foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies.

In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.

Past performance is not a guarantee of future returns.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.

Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

We recommend that you consult a tax or financial advisor about your individual situation. Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.